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Summary:
Bonds quickly reversed their gains and look under further pressure from the goldilocks state of play across financial markets.
Banking on a dovish Fed carries risks
Bunds have tested the 1% yield level again after a 9bp round trip in two days. This is the proof that market moves in illiquid summer months, even more so due to bank holidays in some parts of Europe on Monday, should be taken with a pinch of salt. Bonds more broadly continue to trade weak with a bias toward higher yields evident since the start of the month. We attribute some of the move to better risk sentiment across developed markets, but risks to these goldilocks, neither too hot that central banks need to keep hiking nor too cold that the economy falls off a cliff, state of play abound.
The first and most obvious challenge is that central banks can ill afford a loosening of financial conditions as they still grapple with record high inflation. The Fed is clearly one example but by no means an isolated one. Tonight's Fed minutes might well jar with the upbeat tone evident in many financial markets. Even if investors might be tempted to discount any hawkish concerns as 'pre-CPI peak', the tone of Fed comments since the July FOMC meeting leaves no doubt about their mood. This in turn should result in higher treasury yields, reaching above 3% again, and a softer tone in risk assets.
Both economic optimism and tighter spread look at risk
The discrepancy between soft and hard data in the US continues to drive some of the whipsaw in bond yields. Industrial production yesterday cemented our expectations for a solid 3Q GDP growth, and July retail sales, to be published today, should look equally solid. The contrast with sentiment indicators might only be a matter of timing however, with 4Q growth prospects looking a lot less healthy. It is difficult to imagine markets extrapolating this good stint of positive US numbers for long, with other corners of the economy, most notably housing, heading south.
Another risk is coming from the rise in government bonds themselves. Independent of the tone of central banks, rising core yields bring about wider sovereign spreads. This has been evident in the underperformance of peripheral bond markets this week with greater volatility in core yields also affecting demand for spread products. There is also a looming risk of a profit-taking into the September/October supply window after the gains registered over the summer months. This may not be the case yet but, in the case of sovereign spreads, some investors may well decide that they do not want to go into the last month of Italian election campaign with too much exposure.Today's events and market view
Eurozone 2Q GDP sees its preliminary release today. Consensus is for a print in line with the advanced 0.7% MoM/4% YoY first reading but the focus in financial markets is much more on the energy crunch facing the eurozone economy over the winter months.
The main item on the economic calendar in the US is the July retail sales report. A fall in gasoline prices will depress the headline figure but this should free up cash for other goods and services according to our economics team. This could add to upward pressure on bond yields into the FOMC minutes.
The US Treasury will also sell $8bn worth of 20Y T-bonds.
The main potential market-mover will be later in the session however, in the form of the July FOMC minutes. The majority view is that the Fed can ill afford a further easing of financial conditions if it is to get inflation under control. This argues in favour of an overall hawkish tone coming out of the minutes. Michelle Bowman will also be on the wires.
Source: ING
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